Thursday, April 14, 2011

Say It Ain’t So, Warren

Q. Is there a question about the right way for publicly traded companies to report financial information?

A. I think the principles are cut and dried. The problem often lies in the interpretation of the principles. The basic principle is that anything, positively or negatively, that occurs inside a company or has a reasonable probability of occurring that could be viewed as impacting the information needs of an investor needs to be made public. You need to make it public to everybody at once, not just a select group, or not just dribble it out - fair, prompt and full disclosure.

We were about to begin editing the final draft of our soon-to-be-published ebook, “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett,” when the David Sokol news hit the tape, generating simultaneous emails, phone calls and instant-messages that made it impossible to focus on the task at hand.

David Sokol, as everyone except perhaps a few nomads in the Empty Quarter of the Arabian Peninsula knows, is the Berkshire Hathaway executive who “resigned” suddenly and unexpectedly last month, shocking Wall Street in general and Berkshire Hathaway-watchers in particular.

Why all the shock?

Well, for one thing, Sokol was widely seen as The Successor who would someday take Warren Buffett’s place as CEO of the Berkshire Hathaway family of companies.

That’s a big deal, considering the fact that Warren Buffet is the most successful investor of his times (not hyperbole), and that Berkshire Hathaway, which his investment acumen created, today has more than a quarter-million employees generating close to $150 billion a year in revenues. That’s almost as big as General Electric.

Unlike GE, however, Berkshire’s home office doesn’t occupy a tree-shaded headquarters building in a leafy Connecticut suburb on 68 acres of land with 600,000 square feet of space, dozens of sharp-elbowed Vice Presidents jostling for position, and hundreds of home-office types toiling away.

No, the stingy and bureaucracy-shy Buffett runs Berkshire with the help of just 20 other professionals, in leased space on one floor in downtown Omaha, and he has been publicly discussing what he’s looking for in a successor with the same thoughtful deliberation he uses when discussing stock-picks, the state of the economy, and acquisitions like the recently announced $9.2 billion Lubrizol purchase.

Of course, David Sokol was never actually named Buffett’s successor. Buffett likes the limelight, for one thing; for another, he’ll run Berkshire until he drops dead; and for a third, until that time he can always change his mind about who should succeed him.

Still, so many signs pointed to Sokol over the years that Barron’s once picked him as the heir-apparent in a front-cover story.

Whatever David Sokol’s true position in that horse race, last month’s very public disruption of Buffett’s long-considered plans was surely a shock to the Oracle of Omaha himself, for Buffett thinks not in terms of months and quarters but in terms of years and decades, and he does not often see his well-made plans disrupted—especially not in such an ugly, public way—with the actions and integrity of a Berkshire “All-Star,” as Buffett refers to his managers, suddenly called into question.

This leads to the second, and bigger, reason for the stunned reaction to the Sokol Affair: what Sokol actually did before he “resigned.”

What Sokol did was this: he traded—quite profitably, it appears—in shares of Lubrizol while lobbying Buffett to have Berkshire buy the company. This kind of trading-in-advance-of-someone-with-deeper-pockets-than-you is known as “front-running” on Wall Street, and it is one of the first things even a summer intern learns never—ever—to do.

Sokol, of course, is no summer intern. He’s a veteran, not merely of board rooms but also of the ways of Wall Street. And as the quote at the start of this piece indicates, he is quite familiar with the rules of disclosure for public companies.

Indeed, Sokol’s first experience as president of a public company dates back to 1992, when he took the helm of an obscure but memorable outfit known as JWP (the old Jamaica Water Properties—‘Jamaica’ as in Queens, New York; not as in Bob Marley and the Wailers), where his Chief Financial Officer uncovered questionable accounting practices which Sokol admirably disclosed before submitting his resignation and moving on to the predecessor to MidAmerican Energy, even as JWP was moving on to Chapter 11.

Nor is Sokol some underpaid subaltern for whom the lure of a quick buck might seem too great to pass up.

During his 2000-2010 tenure as Chairman of Berkshire’s MidAmerican Energy group, Sokol earned, by our calculations, total salary of $8.8 million and bonuses of $53.9 million, plus a $26.25 million payout thanks to MidAmerican’s “Incremental Profit Sharing Plan.”

But that was not all David Sokol earned at MidAmerican, for not only did he work at MidAmerican, but Sokol was an owner of MidAmerican.

Now, leveraged buyouts can be risky. On the other hand, they can be highly rewarding, too, as Sokol’s experience shows. All told, from 2000 to 2010, MidAmerican’s filings report he sold a total of $145.5 million in MidAmerican stock or stock-equivalents back to MidAmerican, taking his ownership as of 12/31/10 down to zero.

And Sokol certainly earned his good pay, at least when measured by the gain in MidAmerican's value over the years. When the Buffett and Sokol/Scott/Abel investor group bought MidAmerican in 2000, they paid $35.05 a share. Five years later, MidAmerican paid an implied $145 per share to buy back stock from Sokol, and by 2009 the valuation had increased to what appears to be $175 per share for Sokol’s remaining shares.

It is no wonder Buffett wrote in his March 30 letter, “Berkshire is far more valuable today” thanks to Sokol. And it is unlikely Buffett begrudges one dime of Sokol’s compensation, for Warren Buffett is, as he likes to say, “A pay-for-performance kind of guy.”

Yet Warren Buffett is also a Wall Street veteran. (He first visited the floor of the New York Stock Exchange when he was 10 years old.) And if anybody in the financial world knows “front-running” when he sees it, it would be Warren Buffett.

This brings us to the third, and biggest, shocker of the Sokol Affair: Warren Buffett’s own handling of it.

The way Buffett handled it was through a press release written in the form of a letter that first praised Sokol’s work for Berkshire and then divulged the stunning news that Sokol had bought, then sold, and then bought shares of Lubrizol during a period of time in which Sokol was encouraging Buffett to buy Lubrizol lock, stock and barrel for Berkshire Hathaway—which Buffett eventually would do.

Buffett summed up the matter, and simultaneously tried to close the door on it, by writing, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”

To understand why this rationalization was so head-scratchingly, stop-the-presses stunning, one must understand that for a quarter-century Warren Buffett has been sending a version of the following memo to his managers (David Sokol, no doubt, included) defining what he calls Berkshire’s “top priority”—and that priority is not money:

This is my biennial letter to reemphasize Berkshire’s top priority….

The priority is that all of us continue to zealously guard Berkshire’s reputation. We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.” We must continue to measure every act against not only what is legal but also what we would be happy to have written on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision….

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it’s very likely that if a given course of action evokes such hesitation, it’s too close to the line and should be abandoned. There’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it.

As a corollary, let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile. A reluctance to face up immediately to bad news is what turned a problem at Salomon from one that could have easily been disposed of into one that almost caused the demise of a firm with 8,000 employees.

Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil. But we can have a huge effect on minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety….

That letter was reprinted in the 2010 annual report that went to all Berkshire shareholders a month before the Sokol Affair exploded, and it needs no elucidation.

After all, the sentiments expressed are exactly what Buffett and his long-time business partner, Charlie Munger, have been telling shareholders at his annual shareholder meetings for decades.

Indeed, Munger has proven to be even more emphatic than Buffett when it comes to what constitutes appropriate conduct—“being an exemplar,” as he likes to say. In a speech at Harvard Law School that still circulates on the internet, Munger once discussed the “isolated example of a little old lady in the See's Candy Company, one of our subsidiaries, getting into the till”:

“And what does she say? ‘I never did it before, I'll never do it again. This is going to ruin my life. Please help me.’ …. Well in the history of the See's Candy Company they always say, ‘I never did it before, and I’m never going to do it again.’ And we cashier them. It would be evil not to, because terrible behavior spreads.”

Interestingly enough, Sokol tried to throw Munger under the proverbial bus in a CNBC interview shortly after the Lubrizol trades came to light by claiming his Lubrizol trades—unreported to Berkshire shareholders until after the fact—were somehow similar to Munger’s longstanding and fully disclosed interest in Chinese car company BYD, in which Berkshire subsequently took a stake. (Munger, appropriately, took no part in Berkshire’s BYD investment process—in fact it was Sokol who went to China to look at the company for Berkshire.)

So what did Munger—the man who spoke so sternly about the ‘little old lady’ at See’s Candies—have to say about Sokol’s Lubrizol trades? He called it “a glitch.”

Warren Buffett was right when, explaining the kind of risk-conscious individual he was looking for to succeed him as the Chief Investment Officer at Berkshire Hathaway, he wrote this line in 2006:

A single, big mistake could wipe out a long string of successes.

At the time, of course, Buffett was referring to financial mistakes—the kind of mistakes that brought down Bear Stearns, and Merrill Lynch, and Fannie Mae, and so many others just a few years later.

That those financial mistakes did not happen at Berkshire Hathaway during the worst financial panic since the Crash of 1929 was entirely due the rational, thoughtful, forward-looking individual at the helm of Berkshire Hathaway. Owing to that foresight, Berkshire Hathaway will continue to thrive under Warren Buffett and beyond thanks to the collection of durable companies that now make up most of Berkshire’s assets, even though it will never be the growth machine it was during his stock-picking years.

But the reputational mistake from that single, awful line, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful”—a line that, while factually very likely the truth, just wiped out a long string of reputation-building successes—is not so easy to fix.

What you are reading and hearing is from people who believed—thanks to years of careful studying of what Buffett wrote in those annual letters and careful listening to what he said at those annual meetings—that Buffett meant what he said and said what he meant.

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

25 comments:

Anonymous
said...

Buffett wrote that he did not view Sokol's actions to be unlawful. He did not state that he found them to be ethical, and I suspect Buffett would have a very different answer to that question which will no doubt be asked at the AGM.

I have been waiting for this post. I am 28 years old and have been following Berkshire since taking a value investing class in college. Like many others that you described in your book, I found myself turning into one of the faithful, reading all the letters to shareholders multiple times, attending the meeting, reading all the books (including yours twice), etc.

The one thing that I do not believe has been discussed thoroughly is Buffett's own investment process and how it relates to this matter. Almost every investment decision that I have read about (you probably know more) has been 100% Buffett's final decision (with input from Charlie). While there is no doubt that others may have had some influence in some decisions (BYD, etc.), nobody but Buffett makes the final call and I find it unlikely that someone can really "talk him into something" on a deal of this size or quite frankly on anything. Therefore to me, what Buffett is saying in all of this is, "I knew about the purchases, but no one can convince me to make a deal that I do not think is 100% beneficial to Berkshire shareholders, no matter who they are."

In the end I agree that this doesn’t look good, but taking into account the fact that Buffett really does make the final call on all material investment decisions, it seems to me that this is not as big of a deal as everyone is making it out to be. You said in your book (or maybe the blog about the meeting to approve BNSF) that you can always tell the people who don’t like Buffett, this just seems like their opportunity to finally have their day in the sun.

Would love your comments (and yes it is fine to tell me I am young and naïve). Paul

I found Buffett's seeming lack of care over the matter to be the most disappointing aspect of this.

http://alephblog.com/2011/03/31/regarding-david-sokol-redux/

It would be one thing if Buffett had never said word one on business ethics. It is quite another when you have emphasized it for years, and then to not follow your own principles at the first material test of them.

You're spot on that the wording was undesirable from the Mid-Western Oracle with golden ethics. However, isn't it clear or at least strongly inferred that Sokol left because Buffett found his behavior inappropriate? I feel Warren's actions still scream that he is a solidly, well-principled man.

Jeff, don't you think that, over the years, there were many investments that Sokol has brought up to Buffett and that he didnt even consider? I mean, Sokol is probably there doing a bunch of trades a year on his personal account (as Buffett has previously mentioned about his own personal account investments) that goes unnoticed and this time that's what happened?Aside from this specific issue, I wonder who does the back office work at Berkshire. There must be someone checking the custody and the trades Warren does daily, right?

Well, Mr. Matthews, you deserve a lot of credit for looking at the facts and being willing to reevaluate your position on WB, rather than seek to excuse him or search for reasons to exonerate his behavior in this case as others have done. It shows your intellectual honesty and I for one admire you for it.

Jeff, As always, well done. Mr. Market, in answer to your question, here is accepted practise amongst investment firms. I am a senior fund manager and one of my analysts buys a stock and then recommends it to me for my fund. If I then purchase that stock, he loses the right to any profits on his investment, instead they go to my fund. If he makes the recommendation to me and instead waits an appropriate time after I make my purchases (in my firm's case 2 weeks), then there is no front running issue and any profits are his. What is inexcusable here is that after the fact Buffett didn't insist that Sokol's profits belong to Berkshire and that Sokol didn't volunteer to surrender them. By alerting Buffett to the holdings Sokol probably avoided any legal issues with front running. Ethically he should have conceded the profits. Buffett, by not seizing the profits, failed to look after the fiduciary interests of Berkshire's shareholders - and might well lose a lawsuit were he to be sued over his actions.

Most writers about Warren are more enamored with creating additional mythology about Buffett's saintliness. I'm afraid Sokol is just a small tip of the iceberg.

If you look at the sales generation process of any business, you'll really see how the sausage is made: promises made or promises broken; scams or not. If you spend any time looking at how Wells Fargo or Geico actually extracts money from ordinary customers, you'll see how dear ole Warren has cleverly turned another blind eye. I suggest that you take a real hard look under these rocks. There might be more creepy crawlers scurrying about.

For starters, Paul, who kicked things off by noting that Buffett would not have bought Lubrizol if he didn't think it was a great deal for shareholders, is factually correct.

But it is not Buffett's actions regarding Lubrizol that are the issue. It is Sokol's actions, and Buffett's public response. (And while we won't call you 'young and naive,' Paul, we urge you to read the comment we'll get to in a minute.)

As for the Anonymous comment that Buffett's actions still "screamed" that he is a solidly principled man--well, we think they screamed no such thing, and that was the problem with the press release. Buffett is very quick to call Lehman bankers "carnys" when their behavior offends him...not so David Sokol.

Regarding the 'back-office issue at Berkshire, it seems clear there IS no 'back-office' at Berkshire. That will change.

The final "Anonymous" takes the conspiracy-theory angle on Buffett, without providing any factual basis for the claim that Buffett 'turns a blind eye' on bad business practices at Wells Fargo and GEICO...if he or she had instead highlighted Kirby vacuum cleaners, which essentially sells expensive vaccum cleaners on credit to people who can't afford them, we'd have been more impressed.

It is "Not Allowed to Sign My Name," however, provides the most interesting take of all, and it is from personal, real-world experience. Paul, our self-described 'young and naive' reader who defended the purchase of Lubrizol as being Buffett's alone, without considering Sokol's actions in their own regard, should take a minute and read it.

Demanding fee for being well advised? Is this the answer for Paul, who obviously hit the point? Jeff, I can't believe you ended into that misleading Wall Street reasoning. This case is far from obvious, and this blog inured us to something more than copycatting CNBC's arguments.(No offense, I'm just temporarily shocked)

Anonymous takes umbrage at the term 'conspiracy theorist,' and although there is a fierce contingent of conspiracy theorists who view everything Buffett has ever said/done as a scam, we'll say, okay, to paraphrase the Arctic Monkeys, 'perhaps conspiracy theorist is a bit strong...'

But the Wells Fargo example does not make your case. Berkshire owns a minority interest in WFC and does not have a board seat. Hard to see how everything they do is at the bidding of Warren E. Buffett.

You're read Snowball. I expect you remember that Buffett was a devotee of Dale Carnegie. When has Buffett ever criticized anyone? Pretty much never.

Even when Santulli blew up Netjets you never heard Warren run him down.

I wouldn't take Buffett choosing not to criticize Sokol as an endorsement from Buffett of Sokol's behavior. I'd just take it as Warren being diplomatic and realizing nothing to be gained by criticizing Sokol.

Insider trading aside--and the new Lubrizol filing makes it seem not such a remote possibility---Sokol is just as guilty as a secretary that takes white-out, a factory worker that takes a slightly imperfect shoe for himself off the assembly line or the executive that takes home his old Aeron chair after an office remodel (disclosure: Long Herman Miller).

Deriving benefit from your employer such as a cup of coffee you grab at 4:45 PM and finish on the drive home is one thing. It's incidental. Being central to a transaction and benefiting along the way just because you are there is theft.

I doubt Citi's bankers used Sokol's personal email . He was a Berkshire employee on Berkshire time when he took the meeting.

Your analysis is the best I've seen so far (most everything out there seems to be mindless chatter).

Buffett was magnanimous in making the statement "Neither Dave nor I feel his Lubrizol purchases were in any way unlawful."

This one statement, I feel, is Buffett's parting gift to Sokol, for his many years of dedicated service. This is the best Buffett could do for Sokol, under the circumstances, betrayal of trust by a front runner (sic) among Buffett's successors.

I am making this up (sic), but imagine Sokol being investigated by the SEC for this trade. Sokol may be able to draw comfort from Buffett's statement.

This statement is the best Buffett could do to "hide" Sokol - recall the Polish Jew who said “I am slow to make friends because when I look at people, I have one question in mind — would they hide me?”

That Buffett came up with this statement in a single day, despite emotional toll from the betrayal of trust, speaks to Buffett's rationality in weathering the emotional storm.

Thank you Jeff, for your excellent commentary - keep up the good work.

So we've learned that Warren Buffett is a hypocrite. A word I haven't seen used yet. Maybe his ethics are not always golden.

For example, previous commenter, David Merkel, wrote an article, "What Did Buffett Know about the Gen Re Finite Reinsurance Deal with AIG?" back in 2007. It makes you wonder if Buffett was lying then about his knowledge of a very large Gen Re/AIG "sham" insurance contract.

It may be that Buffett isn't on Wells Fargo's board, but he owns a very, very large piece of it. It would be hard to imagine that this bank's shenanigans wouldn't have crossed his shrewd mind.

And it probably crossed yours as well, Jeff.

But that wouldn't make for mythologizing and apotheosis would it? After all, there many also rans like you who make their living with Buffett-aping and Buffettology. Except that only one man has that scam down right.

Jeff, I love your blog and have read it for years. It is witty, intelligent, reasoned, and generally unbiased. I've been a Buffett fan and Berkshire stockholder for a long time. But starting in 2009 something began to rub me the wrong way. The more I read about Buffett the more he didn't seem to be the guy I thought he was. At one point the accolades I used to share started to grate on me. I really appreciate that you're calling this straight when it would have been easy to gloss it over. You have guts; thank God someone does.